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KASS: Seek assistance on 1031 exchange

DEAR BENNY: My wife and I have an investment home we plan to sell through a 1031 exchange. We plan to use all of the proceeds to buy another home, use it as an investment for one year and then move into it as our principal residence.

We have been advised that although there is nothing specific in the tax codes that prohibits or permits this to be done, renting it out with a bona fide tenant for at least one year and then deciding to “change your mind” at the end of that period and treat it as your primary residence would be “justifiable” if we are audited by the IRS.

Is this correct? – Paul

DEAR PAUL: You have heard the old expression: “When there are two lawyers, there are three opinions.”

Let me first explain “1031.” That is a section in the tax code that allows investors to “exchange” one investment property for another investment property and defer any capital gains tax that would have been required had there just been a straight sale. For example: If I bought a house for $500,000 and exchanged it for a $750,000 house, the tax basis of the new property is the basis of the old property. This is a very simplistic response to a complicated question.

There are rules on how the exchange must take place, which is the subject of another column. Exchanges are also called “Starker exchanges” named after a man who successfully did an exchange.

Lawyers who have written about 1031 exchanges have mixed opinions. Some say that so long as you keep the exchange property invested for at least one year, it will be OK to then turn it into your principal residence; this is called the “old and cold” approach. Other lawyers believe that you should keep the property as investment for at least two tax years.

To be safe, I would hold it as investment for at least two years.

But please let a professional assist you in the exchange process. It sounds easy, but one false step can cost you plenty. For example, if you do a Starker exchange, you sell the relinquished property and all the net sales proceeds must be kept in escrow by an independent person or company. Several years ago, a seller took the sale proceeds check, but immediately decided to do a 1031 exchange and gave the check back to the escrow (title) company.

Tough, said the IRS; you had access to the money – even for one minute – and thus did not comply with the 1031 exchange rules.

DEAR BENNY: I just read your article regarding the minimum documents all people should have.

My late father had all of these documents. However, his wife – my stepmother – who was his legal power of attorney, changed the beneficiary to herself on many of my father’s assets that were not covered under his will.

Many people, myself included, believe that a will covers the decedent’s wishes as to the distribution of all of their assets. They don’t realize, however, that assets with separate named beneficiaries are not governed by their will. People need to be aware that these assets transfer to the named beneficiaries upon proof of death, despite any directives in their will. Additionally, the executors may be unaware these assets exist, and may not know they have been reassigned. These include retirement accounts (IRAs, 401k, 403b), life insurance, and assets in joint bank accounts, which may have really only belonged to the decedent.

Can and should a person name co-durable power of attorneys so that it would take more than one signer to make a change of beneficiary? – Dori

DEAR DORI: Thanks for writing and for your very relevant comments. You make a very interesting observation: Under some circumstances, there should be two people who have to act as powers of attorney, so as to avoid self-dealing on the part of just one of the parties.

Benny Kass is a practicing attorney in Washington, D.C. and in Maryland. He is not providing specific legal or financial advice to any reader. He wants readers to e-mail him, but cannot guarantee a personal response. He can be reached at: mailbag@kmklawyers.com.

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